5. HOUSEHOLDS, FIRMS, INDUSTRY AND MARKET
In micro-economics, behaviour of small economic units, like households, firms, industry and market is studied. It is therefore necessary that we know them clearly and correctly.
(i) Household: In the analysis of a market economy, a household is the smallest economic agent and comprises a group of individuals that constitute a family. Economic decisions are taken jointly by the household.
Households enter the market in two major roles: as consumers (buyers) of goods and services and as sellers of factors of production. Sometimes the term individuals is used in place of households.
(ii) Firm: The second basic unit of economic analysis is the business firm. Like the households, firms have also dual aspects : They buy factors of production from households and use them to produce goods and services. Like households, firms too deal with the outside world through markets. The distinguishing feature between the two is that household consume goods, while firms produce goods.
In neo-classical economics, the term firm is used for the institution which transforms inputs into output. Thus firm is viewed as an abstract entity, an artificial agent, which fulfils mainly a technical role.
While the households are assumed to aim at maximizing utility, firms, in the traditional theory, are assumed to maximize profits. Modern theories of the firm assume that firms may pursue policies other than profit maximization Similarly, modern theory of consumer behaviour has dropped the assumption of utility maximization as is the case with traditional theory (neo-classical theory) and with indifference curve analysis. The firm may be a single proprietorship, a partnership or a corporation.
(iii) Industry: The concept of industry is beset with many difficulties and complexities. So it is not always possible to give a precise or neat definition, “The primary basis for the delimitation of industries is the good or commodity.” In an ideal situation, as in a perfectly competitive market economy, an industry is a group of firms producing a homogeneous commodity, that is, one firm’s product is a perfect substitute of the product of other firms. “As far as each firm involved produces a single uniform product, the industry is also ideally a group of firms producing such a group of perfect substitute products; if the firm produces two non-substitute products, it operates in two different industries.
“Within each industry is a group of producers, few or many, whose individual products or outputs are very close substitutes for each other, but whose aggregate is a much more distant substitute for the outputs of other industries.”
In economic analysis the concept of an industry has its importance in the study of competition. (i) Behind the development of the concept of industry is the attempt to include the firms which are in some form of close relationship with one another. (ii) The concept of the industry “makes it possible to derive a set of general rules from which we can predict the behaviour of the competing members of the group that constitutes the industry.” (iii) The concept of industry gives the framework for the analysis of the effects of entry on the behaviour of the firm and on the equilibrium of price and output.
(iv) Market: Market is a basic concept in economics. Originally market meant a physical place where goods were bought and sold. Now there need be no physical entity corresponding to a market. A market exists when buyers and sellers come in contact with each other. Thus a market is defined in terms of the fundamental forces of supply and demand and need not be necessarily confined to any particular geographical area.
An oft-quoted definition of market is one that has been given by Cournot. He says, “Economists understand by the term Market, not any market place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality easily and quickly.” Jevon gives a similar definition when he says, “Originally a market was a public place in a town where provisions and other objects were exposed fore sale; but the word has been generalized, so as to mean any body of persons who are in intimate business relations and carry on extensive transactions in any commodity.”
This aspect of market has been emphasized in the following definition of market given by Truett and Truett in the 1980s: “A market consists of all of the potential buyers and sellers of a particular good or service.” The development of communications and transport, banking services and scientific grading of commodities have all helped to widen markets. The essential feature of a market, whatever its extent, is that buyers and sellers exchange goods and services. It is enough that there exists a network of telecommunications across the world on which trading takes place.
6. CLASSIFICATION OF MARKET (OR INDUSTRY) OR MARKET STRUCTURES
Individual firms do not function in isolation but operate in an environment which is shaped, in part, by the existence of other firms. This fact has a strong influence on the relationship between the price of the product at which the firm sells and the quantity of output which the firm is capable of selling. If a firm raises the price, it loses sales to other firms; on the other hand, if it lowers price, it gains sales at the expense of other firms.
This involves the question of the intensity of competition and leads to the problem of market structures which has been explored particularly since the 1930s. Earlier discussion of market structures was typically presented on the assumptions of pure (perfect) competition with separate observations on pure monopoly. In pure competition, firms are “price takers”, while a monopoly firm is a “price maker”.
The problem of market structure is an issue of the relationship between each individual firm and other firms in the economy, while the term ‘market structure’ refers to all the features that may affect the behaviour and performance of the firms in a market, such as number of firms in the market or the type of product they sell.
Classification of market or industry or market structures may be simple or complex, depending on the number of criteria that we take into consideration To reduce this analysis to manageable proportion, economists focus on four theoretical market structures on the basis of two criteria, namely,
(i) Relation between the outputs of the firm in an industry, that is, the existence or closeness of substitutes, whether the products are homogeneous or differentiated; and
(ii) The number of firms in a industry: many, few or one; this criterion determines the extent to which firms in an industry take into account the reactions of competitors.
The first is the substitutability of products criterion and the second is the inter-dependence criterion.
Traditionally the following five classes are distinguished:
(i) Industries with one seller: the single-firm monopoly.
(ii) Industries with many sellers:
(a) where the products of all sellers are identical or homogeneous: pure or perfect competition;
(b) where the products of various sellers are differentiated: monopolistic competition.
(iii) Industries with a few sellers:
(a) where the products of all sellers are identical or homogeneous: pure oligopoly,
(b) where the products of various sellers are differentiated: differentiated or impure oligopoly.
(i) Single-firm Monopoly or Monopoly
In this situation there is only one firm in the industry and there are no close substitutes for the product of the monopolist. Cross-elasticity of demand with every other output is very small. The monopoly firm assumes all the characteristics of the industry and so its demand curve coincides with the demand curve of the industry. Monopolist’s demand curve slopes downward to right like any industry demand curve. Entry is blocked.
(ii) Pure or Perfect Competition
There is a large number of firms in perfect or pure competition, all of whom sell a homogeneous (identical) product. Many sellers mean that they are relatively small and so no one of them sells a significant portion of the total market supply. “No seller, either by extending his own output even by a large percentage or by withdrawing it entirely, can perceptibly influence the market price of his product.”- All firms in pure competition are price-takers.
In such a situation, every firm considers that it can sell any amount of output it wishes at the going market price. So the firm faces an infinitely elastic demand curve, that is, the price elasticity of demand for the individual firm is infinity.
Sometimes a distinction is made between pure competition and perfect competition. The following three assumptions are necessary for pure competition:
(i) Large number of firms in the industry;
(ii) All firms producing a homogeneous product; and
(iii) Free entry, that is, anyone who wishes to enter a competitive industry is free to do so.
For perfect competition, it is necessary to make some additional assumptions besides the three given above in the case of pure competition. Additional assumptions are:
(iv) perfect knowledge on the part of all buyers and sellers about the conditions in the market;
(v) complete mobility of factors of production between industries; and
(vi) no transportation costs as all producers work sufficiently close to each other.
(iii) Monopolistic Competition
Monopoly and perfect competition are two extreme cases, far removed from reality. Most real markets lie between these two limits. “In practice the situation in an industry is very frequently that there is neither one seller nor very many small sellers; moreover, the products they sell, regardless of their numbers, are usually not identical but differentiated in some degree.” Thus the remaining three categories of market classification are factually more important than the two discussed above. These three categories are:
(i) industries with few sellers selling identical products or pure oligopoly;
(ii) industries with few sellers selling differentiated products, or differentiated oligopoly; and
(iii) industries with many sellers and differentiated products, or monopolistic competition.
Product differentiation means that the products of different firms in the industry, although close substitutes to buyers, are not perfect substitutes, and are distinguished by design, quality packaging, brands or sales promotion.
Monopolistic competition refers to a market structure in which there are many sellers with differentiated but close substitute products. By “many sellers” is meant that each seller is so small that no one seller controls a significant proportion of the total market output. No firm by extending or reducing its output within considerable limits can affect the sales of any other seller enough to induce a direct retaliation. The demand curve of the individual firm slopes downward to the right, but its price elasticity is high due to the existence of close substitutes.
The name ‘monopolistic competition’ suggest that such a market structure combines the element of monopoly with that of competition. Every firm in monopolistic competition assumes some monopoly power because of product differentiation and faces competition because of the largeness of number of sellers. However, the competitive element is stronger than the monopoly aspect.
The term monopolistic competition used here to refer to a restricted market category. Chamberlin, in his Theory of Monopolistic Competition, uses the term in a broader sense to include all pricing where there is product differentiation within the industry. Thus the case of a few sellers (oligopoly) is also included in monopolistic competition (the case of many sellers)-product differentiation being the common feature in both.
(iv) Oligopoly
Oligopoly is the case of a few sellers producing either close or perfect substitute product-known as pure oligopoly; or differentiated products known as differentiated oligopoly. The oligopoly firms are few enough and large enough so that each controls enough of the total industry output. Consequently, a moderate expansion of output by one firm will reduce the sales of rival firms by a significant amount. Oligopoly may be of the following two types:
(i) two or three up to perhaps a dozen firms control the entire industry output with each controlling enough to affect rivals by its output changes; and
(ii) a more complex form of oligopoly when a few sellers in an industry control a significant proportion of industry output-perhaps 80 to 90 percent—but the remainder of the industry output is supplied by many small firms with very small individual shares of the total output. This situation may called “oligopoly with a competitive fringe.”
There are two main distinctive features of oligopoly which distinguish it from the three other classes of industries or market structures discussed above. First, in the case of monopoly, perfect competition and monopolistic competition, the seller faces a unique and definite demand curve indicating the relation of his price to his demand (that is, his sales volume). Individual seller’s demand curves in these three cases are as given below:
It can be seen in the figures that individual seller’s demand curve in perfect competition is perfectly elastic, whereas in the other two cases demand curves are negatively inclined in such way that the demand is highly elastic but not infinity in monopolistic competition and inelastic in monopoly. However, in all the three cases there are definite demand curves. There is no such definite demand curve in oligopoly.
Second, the dominant feature of the individual seller’s demand curve in oligopoly is that it is not definite but uncertain because his own output adjustments are likely to lead to retaliatory action by his rivals in an unpredictable manner. This retaliatory action is the result of the fact that each seller in oligopoly controls a significant proportion of the industry output. If one oligopoly seller changes the price of his product, his rivals cannot take it lying down. A price change by one seller is always promptly matched by the other firms in the industry.
This type of reaction is not expected in the three other forms of market structure. In monopoly there is only one seller and his product has no close substitute. So his action in respect of price or quantity changes causes no reaction from other firms. In the other two cases of perfect competition and monopolistic competition, an individual seller is so small that any price or output change caused by him creates no perceptible impact on other firms’ sales.
Therefore it leads to no retaliatory action. Consequently, individual demand curves in these three forms of industries are definite and certain. But there is no typical demand curve facing an oligopoly firm because of the inter-dependence of sellers.
7. WORKING OF PRICE MECHANISM
In order to understand the working of the price mechanism properly, we must start with the concept of the market economy. In a market economy, crore of consumers decide what commodities to buy and in what quantities; a large number of firms produce these goods and services and buy inputs (factors of production) that are needed to make them. Similarly, crore of owners of factors of production decide to whom and on what terms to sell their services. “These individual decisions collectively determine the economy’s allocation of resources among competing uses.”
The true miracle of the market economy is that it works without coercion or centralized direction by anybody. Crore of businesses and consumers engage in voluntary trade. Their actions and purposes are invisibly coordinated by a system of prices and markets.
Thus a “market economy is an elaborate mechanism for co-ordinating people, activities and businesses through a system of prices and market….Without central intelligence or computation, it solves problems of production and distribution involving billions of unknown variables and relations, problems that are far beyond the reach of even today’s fastest super computer. Nobody designed the market, yet if functions remarkably well. In a market economy, no single individual or organization is responsible for production, consumption, distribution, and pricing.”
In a market economy, everything has a price which is the value of the goods in terms of money. Prices represent the terms on which people and firms voluntarily exchange different commodities. Prices further serve as signals to producers and consumers. When consumers want more of any good, its price will rise. It sends a signal to producers that more of the commodity is needed. It encourages producers of it to increase its production.
Price mechanism is a term used with reference to the free market system and the way in which prices act as automatic signals which coordinate the actions of individual decision making units. “By means of this role, the price system provides a mechanism whereby changes in demand and supply conditions can affect the allocative efficiency of resources.”
Prices co-ordinate the decisions of producers and consumers in a market. When prices rise, consumers reduce their purchases and producers increase production. Lower prices encourage consumption and discourage production. “Prices are the balance wheel of the market mechanism.” In the goods market. prices are to balance consumer demand with business supply, while prices in factor markets are set to balance household supply with business demand.
8. TOTAL, AVERAGE AND MARGINAL MAGNITUDES
In economics, ‘at the margin’ means at the point where the last unit is produced or consumed. A marginal unit is the extra unit of something, such as marginal revenue, marginal cost, marginal utility, etc. A marginal change is a very small increment or decrement to the total quantity of some variable. Marginal analysis is the analysis of the relations between marginal changes in related economic variables.
Much of micro-economics is concerned with the analysis of optimizing behaviour, that is, the search for the optimum values of particular variables. Thus the consumer is assumed to maximize utility; the firm is assumed to maximize profit and, in doing so, to minimize costs for every level of output; the policy-maker is assumed to maximize social welfare. The search for optimum values involves marginal analysis. The marginal analysis is very closely related to the mathematical tool of optimality analysis—the differential calculus.
The arithmetic of marginal analysis is explained below with the aid of Table.
In the table x stands for any magnitude like revenue, cost, utility or profit. First column indicates units or quantity, while the second, third and fourth columns stand for total, average and marginal magnitudes.
In order to have a clear understanding of the relationship, let us assume that the numbers are the marks obtained by six students at an interview. When no student appears at the interview, total mark is zero. There is no addition to the total, so marginal mark is also zero. There is no meaning of average mark in this case as no one is interviewed. The first student gets 100 marks.
It means that total of all marks is 100 and the average is also 100, while marginal marks too are 100 (marginal marks = addition to total marks = 100). The second student gets 150 marks (marginal marks = 150) which brings the total up to 250 and pulls up the average to 125 [(100 + 150)/2 = 125] and so on.
The marginal figure is defined as the amount which is added to the total by the marks obtained by each additional student. The average is the arithmetic mean obtained by dividing the total by number of units.
Suppose,
x (in the table above) is revenue and Q = quantity, TR = total revenue, MR = marginal revenue, AR = average revenue=P (Price).
We have,
TR=P. Q = PQ
AR = TR+Q=P
MR = ∆R/∆Q,
where ∆ = change (increase or decrease)
The relationships among total, average and marginal magnitudes are as given under:
Proposition 1: The total, average and marginal figures for the first unit are identical (so long as total x for the zeroth unit is zero).
Proposition 2: The total figure is always the sum of the preceding marginal figures.
For example, the total marks of four students, 400, are the sum of the marginal marks of these students, 100 + 150 + 80 + 70.
Proposition 3: When the total magnitude is rising, the corresponding marginal magnitude is positive.
Proposition 4: When the total magnitude is falling, the corresponding marginal magnitude is negative.
Proposition 5: When the total magnitude reaches a maximum (or a minimum), the corresponding marginal magnitude is zero.
Proposition 6: When the average magnitude is falling, the marginal magnitude must lie below it.
Proposition 7: When the average magnitude is rising, the marginal magnitude lies above it.
Proposition 8: When an average magnitude is neither rising nor falling (at a maximum or minimum), the marginal magnitude equals the average magnitude.
Proposition 9: For the average to rise, the marginal figure must be above the average figure; for the average to remain unchanged, the average and marginal figures must be equal; for the average to fall, the marginal figure must be below average.